Colorado Court Reviews Classical and Modern Approaches to Anti-Assignment Clauses, and Holds That Assignment of Member's LLC Interest in Violation of Operating Agreement Is Void
Many LLC operating agreements prohibit or limit transfers of member interests. What’s the result if a member transfers its interest notwithstanding the operating agreement’s prohibition on transfers? Is the transfer void, in which case the transferee receives nothing? Or is the transfer effective, even though the transferor is in breach of the agreement and may be subject to a breach of contract claim by the LLC or other members? That was the question before the Colorado Supreme Court last month in Condo v. Conners, No. 10SC703, 2011 WL 6318980 (Colo. Dec. 19, 2011).
Thomas Banner was one of three members of Hut at Avon, LLC, a Colorado limited liability company. As part of a divorce settlement, Banner agreed to assign to Elizabeth Condo, his ex-wife, the right to receive monetary distributions on his LLC interest, and to vote against all issues that under the LLC agreement required unanimous consent unless his ex-wife directed otherwise. The LLC’s operating agreement limited the assignability of member interests, stating that “a Member shall not sell, assign, pledge or otherwise transfer any portion of its interest in” the LLC “without the prior written approval of all of the Members.” Id. at *5.
Banner contacted the two other members and requested approval of the proposed assignment. The two others objected, but Banner later went ahead without their consent, assigned his rights to his ex-wife, and promised to vote as required in the divorce settlement. When the two other members learned of the assignment they complained and offered to buy Banner’s interest in the LLC. Ultimately Banner sold his entire interest in the LLC to the two other members.
Condo then sued the two LLC members and their attorney for tortious interference with contract and civil conspiracy. She claimed that they conspired with Banner in bad faith to buy his interest at a “fire-sale” price, destroying the value of her right to receive Banner’s distributions and interfering with Banner’s assignment to her.
The trial court reasoned that Condo’s claims were dependent on the validity of the assignment, and found the assignment to be invalid because it was made without the consent of the two other members. The assignment was void as against public policy because the lack of consent from the other members constituted bad faith by Banner. The trial court therefore dismissed Condo’s tort claims. Condo appealed, and the Court of Appeals affirmed on other grounds. Id. at *4.
Colorado’s Supreme Court began by noting that the appeal turned on the validity of the Banner assignment, because Condo’s tort claims of interference and civil conspiracy with contract required the existence of a valid contract. The court then addressed the defendants’ argument that the LLC’s operating agreement should not be interpreted in accordance with prevailing contract law, but instead should be viewed as a constitution or a charter rather than a contract. As such, the operating agreement was claimed to restrict the power of a member to assign his interest, without regard to any potential exception found within contract law. The court disagreed, finding that the Colorado LLC Act and the language in the operating agreement established the operating agreement as a conventional, multilateral contract that should be interpreted in light of prevailing contract law principles. Id. at *5.
Condo did not dispute the restrictive language in the operating agreement or that the two other members never consented to Banner’s assignment. The gist of her argument was instead that (a) the restrictive clause limited only the assignment of duties, not the assignment of contractual rights, and (b) even if the assignment did violate the LLC agreement, it was still effective to convey the member interest to her, notwithstanding Banner’s breach of the restriction and his resulting exposure to a breach of contract claim by the LLC. Id.
The court briskly disposed of the contention that the restrictive clause applied only to duties and not to an assignment of rights to receive distributions. The court referred to the anti-assignment language in the operating agreement – “a Member shall not sell, assign, pledge or otherwise transfer any portion of its interest” (emphasis added) – and pointed out that the LLC Act’s definition of “membership interests” includes a member’s right to receive distributions. See Colo. Rev. Stat. § 7-80-102(10). The court found that the right to receive distributions was included within the broad prohibition on transfers of any portion of a membership interest. Condo, 2011 WL 6318980, at *6.
The court then examined whether the nonconforming assignment was void or whether it was legally effective despite its noncompliance with the anti-assignment clause. If Banner had no power to make the assignment, it was void and Condo’s interference claim failed. “If, in contrast, Banner had the power but not the right to make the assignment, the assignment can be said to have occurred – albeit wrongfully – and Condo’s present claims against the defendants may survive summary judgment.” Id. at *7.
The court reviewed what it termed the classical approach and the modern approach to anti-assignment clauses. In the classical approach, an assignment that violates an anti-assignment clause is void from the beginning because the assignor has no power to make the assignment. In the modern approach, by contrast, an anti-assignment clause is seen as creating a duty to refrain from making a nonconforming transfer, but not as limiting the transferor’s power to make the transfer. In the modern approach the unlawful transfer is not void but is a breach of the obligation not to transfer, which the LLC can then enforce with a suit for breach of contract.
Under the modern approach the unlawful transfer is void only if the anti-assignment clause specifically states that a nonconforming assignment is “void” or “invalid” (sometimes called the “magic words” approach). Id.
The court ultimately held that the LLC agreement’s anti-assignment clause rendered Banner powerless to assign any portion of his membership interest, and that Banner’s assignment was therefore void and could not support Condo’s claims of tortious interference with contract and civil conspiracy. Id. at *10. In reaching its conclusion the court relied on two principles to reach its conclusion: maximizing freedom of contract, and the “pick your partner” policy.
The court recognized the strong public policy of the LLC Act in favor of freedom of contract: “It is the intent of this article to give the maximum effect to the principle of freedom of contract and to the enforceability of operating agreements.” Colo. Rev. Stat. § 7-80-108(4). The court saw this policy as favoring the ability of a party to contractually restrict the ability of other parties to assign their rights. Condo, 2011 WL 6318980, at *8. The court also saw “a clear public policy in favor of allowing the members to tightly control who may receive either rights or duties under the operating agreement,” at least in the context of a closely held LLC. Id. at *9. The court was reluctant to force LLC members to deal with strangers with whom they had not contracted.
Although the court’s result appeared to reject the modern in favor of the classical approach, the court characterized its determination as a “facts and circumstances” analysis:
[W]e narrowly hold that the strict “magic words” approach is inapplicable to the present case. “Whether an attempted assignment … must fail because the rights or duties are of too personal a character is a question which turns upon the express or presumed intention of the parties, which must be ascertained from the entire contract, giving due consideration to the nature of the contract and the surrounding circumstances.”
Id. (ellipsis in original) (quoting 6 Am. Jur. 2d. Assignments § 27 (2011)).
The rule of the case is fairly clear for closely held LLCs, such as Hut at Avon (three members). Unfortunately it is not clear how to apply the court’s holding to other fact patterns. What facts and circumstances will be deemed relevant, when the court relied only on the pick-your-partner principle and freedom of contract in reaching its conclusions? As Justice Eid said in her concurring opinion, “The majority thus leaves open the possibility that, under different circumstances, the ‘modern approach’ might apply to an operating agreement with anti-assignment language similar to this one. This approach renders virtually every such anti-assignment provision open to challenge.” Id. at *12 (Eid, J., concurring) (citation omitted).
